Government's Monetary and Fiscal Policies are the Main Source of Economic and Financial Instability

"There is an urgent need to recognize that financial
markets, far from trending towards equilibrium, are inherently unstable." -GEORGE
SOROS

In the aftermath of the collapse of emerging economies in
Asia, eastern Europe, and Latin America, many prominent economists and speculators,
from Paul Krugman to George Soros, have called for government intervention in
financial markets. Recommended policies include monetary inflation and currency
controls. The foundation of such state interference is the belief that free
markets in general, and financial markets in particular, are inherently
unstable and require strict government regulation. The fathers of this thesis
are the British economist John Maynard Keynes and his principal heir, Hyman ~
Minsky, who devised a "financial instability hypothesis." Minsky, a
Harvard-taught economist, wrote many books and articles during his academic
career of nearly 50 years, most of which he spent at Washington University in
St. Louis. He died in 1996. According to Minsky, Keynes's general theory of the
economy was really a financial theory of uncertainty and expectations. According
to this thesis, the capitalist economy is primarily ruled by Wall Street, which
is fundamentally fragile and destabilizing owing to excessive debt, lax
government rules, and businessmen's "animal spirits" and "waves
of irrational psychology." (Conservative economist Allan H. Meltzer of
Carnegie Mellon University makes the same point.2). In the Keynes-Minsky model,
full employment in an unregulated market economy is not a natural equilibrium
point, but a transitory moment in a business cycle. Euphoric expectations lead
to an overleveraged condition where the rate of credit expansion exceeds the
rate of profit in the economy. Eventually, the boom turns into a debt deflation
and depression.

Long-Run Damage by Government
Intervention

To stabilize the business cycle, Keynesians favor big-government
capitalism where central banks and the International Monetary Fund play major
roles as lenders of last resort. Keynes advocated the "socialization of
investment" and taxes on short-term trading. However, Minsky rightly
pointed out that interventionist policies validate the existing fragile financial
structure and allow the problems to deepen. He warned that "Once borrowers
and lenders recognize that the downside instability of profits has decreased there
will be an increase in the willingness and ability of business and bankers to
debt finance." Larger and more frequent interventions become necessary to
fend off debt deflations and recessions. Minsky correctly criticized
neo-classical economics for largely minimizing the impact that financial
markets can have on economies: "The neo-classical synthesis became the
economics of capitalism without capitalists, capital assets, and financial
markets." My only problem with Minsky is that he mistakenly blames the
market itself for its instability.

Mises's
Non-Neutrality Thesis

To understand the root cause of financial and economic
instability, we need to go back to Ludwig von Mises's
"non-neutrality" thesis in his breakthrough work The Theory of Money
and Credit. Mises pointed out that monetary intervention (easy money policies and
artificial lowering of interest rates) is the principal source of uncertainty,
false expectations, and excessive debt-leverage in the economy and on Wall
Street. Under a stable monetary system, a laissez-faire economy would suffer
occasional financial mishaps, bankruptcies, and down-days on Wall Street, but
there would be no systematic "cluster of errors" that currently characterize
today's global economy. Fortunately, most economists now recognize that government's
monetary and fiscal policies are the main source of economic and financial
instability in the world today. In fact, more and more college textbooks teach
up front that the economy is relatively stable at full employment; this is
known as the "long term growth model." The short-term Keynesian model
is taught at the end of the textbooks, where government intervention is recognized
as a destabilizing factor in the economy and the chief cause of the boombust cycle.
See Roy Ruffin and Paul Gregory's Principles of Economics and N. Gregory
Mankiw's Economics. Maybe George Soros needs to take a refresher course from
these textbooks.

Unfortunately, as opposed to wages, real economics knowledge is not sticky as advocates of the Keynesian model have been on the front pages of main stream media now for years once again. Many economists and politicians come to believe in government/central bank intervention when an economy heads for the worse (e.g. 2000, 2001 and 2008 and ever since), even when the boom was created by easy money and low interest rates (as is normally the case). And as long as governments and central banks have monopoly on setting interest rates and the ability to create fiat money through the fractional reserve banking system, this will always be the case. And as long as that is the case, booms and busts will continue to occur as the temptation to use these "tools" for short term imaginary gains are simply irresistible. Hence, republican vs democrat is a trivial issue while free markets vs crony capitalism, big government and central planning is not.